This Could Be Even Better Than ETFs

When it comes to ease of trading, breadth of offerings, and simplicity of use, it's hard to beat exchange-traded funds. That's one reason why ETFs have taken the investing world by storm lately.

But ETFs aren't the only investing products you can find trading on stock exchanges these days. A similar sounding investment vehicle, the exchange-traded note or ETN, has also made big inroads among investors. But despite their similar names, ETNs are definitely not the same as ETFs, and you should know the pros and cons of each before choosing which type of exchange-traded product you want in your portfolio.

What's in a name?The biggest thing that ETFs and ETNs share in common is that they're both traded on exchanges. Anytime the stock market is open, you can buy and sell shares of ETFs and ETNs.

But when you look more closely, you'll discover some fundamental differences between ETFs and ETNs. As funds, ETFs hold assets -- typically assets that are connected to the investment objective of the fund. So with an S&P 500 ETF, you'll usually find shares of stocks in the S&P 500. Some ETFs use regular stocks and bonds as holdings, while others use derivatives like futures contracts or swap agreements. But you'll always find something among an ETF's daily holdings that's backing up the fund.

On the other hand, as notes, ETNs don't have any backing at all. Rather, they represent unsecured debt from the financial institution that issues the notes. Although you can expect the ETN issuer to hedge its financial risk by taking positions related to whatever index the ETN is supposed to track, there's no requirement that the issuer do so. At the end of the day, all you're entitled to is whatever the prospectus defines as the return on your investment.

The biggest potential risk of an ETN is that the issuer won't be able to repay the note. With issuers including Barclays (NYSE: BCS) , Goldman Sachs (NYSE: GS) , and Morgan Stanley (NYSE: MS) , few investors worried much about default -- until the financial crisis and the failure of Lehman Brothers, which left investors of its ETNs left with unsecured claims in the company's bankruptcy proceedings.

The biggest advantage is the way ETNs get treated for tax purposes. As debt, ETNs are eligible for long-term capital gains treatment, and they typically don't generate income until you sell them or they mature. Moreover, especially with commodities, they avoid the pitfalls that some ETFs have. For instance, the Internal Revenue Service treats iShares Silver Trust (NYSE: SLV) as a collectible, with a 28% maximum capital gains rate. But UBS E-TRACS CMCI Silver ETN (NYSE: USV) , which uses futures to track silver prices, doesn't get collectible treatment, qualifying for 15% maximum rates.

In addition, ETNs can make taxes less complicated. For instance, investors in master limited partnerships like Inergy (NYSE: NRGY) and Kinder Morgan Energy Partners (NYSE: KMP) get K-1s every year, which can make tax filing much more complex. ETFs owning MLPs directly don't avoid that tax hassle. But an ETN like JPMorgan Alerian MLP Index gets the simpler tax treatment of a note.

Finally, ETNs typically avoid tracking error. With ETFs, you have to rely on the investments that a fund makes in order to see if it actually matches the index it uses as a benchmark. In some cases, bad investment choices from ETF managers leave your returns falling short. But with ETNs, the definition of the return is in the prospectus, and so it's just a matter of calculating it when the note matures to determine what you'll receive.

Weighing the risksETN investors shouldn't underestimate the potential pain from counterparty risk. Lehman's failure shows how real that risk is. But for many investors, the tax advantages of ETNs may outweigh that risk. That's why keeping ETNs in mind as a valid investment option can help enhance your returns.

Despite the potential benefits of ETNs, ETFs still play a useful role for most investors. Here at The Motley Fool, we've found three ETFs with great prospects. Sign up here for our free special report to learn more.

Fool contributorDan Caplingeris always looking for a better mousetrap. You can follow him on Twitter here. He owns shares of iShares Silver Trust. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policygives you the best.

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

@tomcypert - I'm aware of one ETF, Alerian MLP ETF, that doesn't have to issue a K-1. But the way it gets around it is by adopting a structure unlike most ETFs: it isn't a registered investment company.